Commodity Trading Advisors – Derivatives & Repo Reporthttps://www.derivativesandreporeport.com
A Buy-Side Guide to Regulatory and Transactional Issues Related To Derivatives and Repurchase AgreementsThu, 14 Feb 2019 21:34:13 +0000en-UShourly1https://wordpress.org/?v=4.9.10Cryptocurrency Derivatives, Funds and Advisers: Key Considerations Under U.S. Commodity Laws (Part 4: About the Interests of Interest)https://www.derivativesandreporeport.com/2018/10/cryptocurrency-derivatives-funds-and-advisers-key-considerations-under-u-s-commodity-laws-part-4-about-the-interests-of-interest/
Thu, 25 Oct 2018 23:10:08 +0000https://www.derivativesandreporeport.com/?p=2847Continue Reading]]>This post is the fourth in a series that outlines key considerations for investment funds and their advisers regarding the application of the U.S. commodity laws to cryptocurrency derivatives. This post is intended to be a primer on the topic and is not legal advice. You should consult with your counsel regarding the application of the U.S. Commodity laws to your particular facts and circumstances.

In this Part 4, we discuss the commodity interests that are likely to be of greatest interest to crypto funds and advisers: futures contracts, swaps and retail commodity transactions.

At the outset, a sincere thanks goes out to Conor O’Hanlon and Michael Selig for their invaluable assistance and time spent thinking through many of the issues that are at this heart of this post and, more generally, this series.

Background: Mandatory Intermediation of Derivatives Trading (…And That’s What Its All About)

The intermediation of derivatives trading is a concept that is fundamental to the substantive regulation of commodity interests under the CEA. For example, only certain market participants, known as “eligible contract participants” (or “ECPs”), are permitted to enter into privately negotiated, bi-lateral transactions that involve commodity interests. Or, put differently, the CEA and related CFTC regulations require non-ECPs to enter into commodity interest transactions, including derivatives, through a regulated intermediary (i.e., a futures commission merchant) and over a regulated exchange (i.e., a futures exchange). In addition, the CEA mandates that certain types of commodity interests (e.g., certain interest rate swaps) be executed through a central trading facility (i.e., a swap execution facility or futures exchange), notwithstanding the fact that both parties to the trade may qualify as ECPs.

As a threshold observation, this bedrock regulatory principle (i.e., mandatory intermediation) can be viewed as being at odds with the disintermediation that underlies distributed ledger technology, generally, and the use of smart contract technology for financial transactions, in particular. We may explore aspects of this possible incongruity between regulation and technology in a later post. But, for purposes of this post, it is sufficient for us to observe that the principle of what we refer to as “mandatory intermediation” is enshrined in the text of the CEA and the CFTC’s regulations. Therefore, we believe that an understanding of this principle is central to the proper understanding of the regulation of commodity interests under the CEA.

Who – or what – is an ECP?

This is a logical “next question,” given the prominent role of the ECP concept in the architecture of the CEA and related CFTC regulations.

As a purely legal matter, an ECP is a market participant that satisfies the applicable criteria established by the definition of the term “eligible contract participant” in section 1a(18) of the CEA and CFTC Regulation 1.3.

More practically speaking, cryptocurrency funds and advisers can think of the ECP concept as being similar to the accredited investor concept under the U.S. securities laws. Although, for certain investors the dollar thresholds to qualify as an ECP may be higher than the thresholds required to qualify as an accredited investor.

An investment fund must have $5 million in total assets in order to qualify as an ECP (assuming that the fund does not trade certain foreign exchange forwards or derivatives enumerated in the CEA and has not been established to evade the requirements of the CEA, including those that apply to commodity interest transactions).

The total asset test for other types of entities can be as high as $10 million in total assets, while natural persons must possess “amounts invested on a discretionary basis” of $10 million. (In addition, a lower dollar threshold may apply to an entity or a natural person that satisfies certain risk management standards established by the relevant provisions of the laws.)

There are other ways to qualify as an ECP, although we focused on these examples since they are most likely to be of interest to cryptocurrency funds and advisers.

Futures (Technically, “Contracts of Sale of a Commodity for Future Delivery”)

As noted in Part 1 of this series, the CEA uses the phrase “contract of sale of a commodity for future delivery” to describe what most market participants call a “futures contract”. Futures contracts can be entered into by ECPs and non-ECPs alike, provided that the purchaser or seller of the futures contract accesses the market through a regulated market intermediary known as a futures commission merchant or “FCM” (or perhaps qualifies as some other type of regulated market participant).

Any fund or adviser seeking to trade a crypto futures contract will need to open an account and enter into a futures customer agreement with an FCM. Futures are traded over an exchange, known as a designated contract market (for purposes of this post, we use the more colloquial term, “futures exchange”). An FCM has “privileges” that allow its customers (e.g., the fund) to access the futures exchange for trading purposes. Additionally, all exchange-traded futures contracts are cleared through a derivatives clearing organization (or “DCO”), which is often said to become the “buyer to every seller and the seller to every buyer”. While that statement is somewhat of an oversimplification of a complicated market structure, it is largely accurate in conveying the idea that the DCO effectively establishes a centralized risk sharing framework for the futures markets that is intended to ensure that parties to futures contracts can perform their obligations under that contract. It is for this reason that an FCM can be thought of as the “front line credit officer” for the broader derivatives markets and, as a result, many funds and advisers spend time negotiating provisions in futures customer agreements that relate to liens, termination and set-off rights, and collateral (or margin) requirements.

Swaps (Among Other Things)

The current iteration of the term “swap” was added to as section 1a(47) of the CEA in 2010, as part of the Dodd-Frank Act’s overhaul to the U.S. financial markets. Section 2(e) of the CEA makes it unlawful for a non-ECP to enter into a swap, unless it is entered into over a futures exchange.

The definition of a swap under the CEA is very broad (and rightfully the subject of a post of its own), since any “agreement, contract or transaction” could be a swap if it:

Requires a payment or delivery to be made by one party to the arrangement based upon the change in the value of an asset without conveying a direct or indirect ownership interest in that asset;

Is an option of any kind on any asset other than a security; or

Requires that a payment or delivery be made based upon the occurrence, non-occurrence or the extent of the occurrence of an event with a potential, financial, economic, or commercial consequence.

Considerable attention and effort has been made by a wide range of derivatives market participants to understand the scope of this definition in a variety of industries and applications. Nevertheless, the analysis of whether a particular agreement, contract or transaction may be an inadvertent swap remains a nuanced and complex exercise, especially in the context of whether a particular crypto investment or product may constitute an inadvertent swap.

At present, different types of swaps (such as non-deliverable forwards and options) are available for trading by crypto funds and their advisers. These transactions constitute “orthodox swaps” (see Part 3, for additional information as to the meaning of this term), since they are intended to be traded and regulated as derivatives. Although, liquidity in these products does not seem to be as deep as with other derivatives, most likely due to the novelty of the cryptocurrencies relative to traditional asset classes like interest rates and fiat currencies.

Retail Commodity Transactions

Section 2(c)(2)(D) of the CEA defines a retail commodity transaction as an agreement, contract or transaction that is offered or entered into by a party:

on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis; and

to or with persons who do not qualify as an ECP (or a sub-category of ECP known as an “eligible commercial entity,” the discussion of which is beyond the scope of this posting).

If both parties to a transaction are ECPs, then the transaction is NOT a retail commodity transaction (although, depending upon facts and circumstances, that transaction may constitute a swap). If one of the parties to the transaction is not an ECP and the transaction involves leverage, margin or financing , then this category of commodity interest is likely to be relevant or, at a minimum, should be analyzed to determine whether it is relevant.

Section 2(c)(2)(D) of the CEA effectively makes it unlawful for a retail commodity transaction to be entered into, unless it is entered into over a CFTC-regulated exchange and through CFTC-regulated intermediaries. To our knowledge, no such regulated exchanges or intermediaries offer trading that involves the use of borrowed funds or property to purchase or sell crypto (i.e., “buying on margin” or “short sales” of crypto, respectively), or what can be described as “debt-based” or “financed” retail commodity transactions. (As more fully developed below, we distinguish such retail commodity transactions from those that involve leverage.)

One notable exception from the regulation of a transaction as a retail commodity transaction can be found in section 2(c)(2)(d)(ii), which exempts a transaction that settles by “actual delivery” of the commodity within 28 days. The CFTC is in the process of considering the issuance of guidance regarding what constitutes “actual delivery” of a crypto for purposes of this carve-out from retail commodity regulation.

Some Final Thoughts: Leverage, Margin or Financing

The concepts of “leverage, margin, and financing” are not well-developed for purposes of the retail commodity transaction definition or the CEA more generally. It would seem that a transaction that involves the use of borrowed funds or property to purchase or sell crypto (i.e., “buying on margin” or “short sales” of crypto, respectively) implicates the retail commodity transaction analysis. (For more information on this aspect of the retail commodity transaction definition, please our 2016 posting Making Sense of the CFTC’s Enforcement Order and Settlement with Bitfinex.)

The CFTC appears to be of the view that indebtedness in the traditional sense (i.e., the use of borrowed money) is not required in order for a transaction to constitute a retail commodity transaction, based upon a recent enforcement action filed by the CFTC in the U.S. District Court for the District of Columbia (CFTC v. 1Pool Ltd. and Patrick Brunner, Case 1:18-cv-2243, filed Sept. 27, 2018 (“1Pool Ltd.“) . In particular, 1Pool Ltd. involved a particular type of derivative known as a “contract for differences” or “CFD,” which the CFTC defined in that action as “[A]n agreement to exchange the difference in value of an underlying asset between the time at which the CFD trading position…is established and the time at which it is terminated.” Paragraph 25 of 1Pool Ltd.

The case did not make any mention of any sort of loan, borrowing, or other debt-based financing arrangement, so it is reasonably to assume that the economic leverage involved in many derivatives is a type of “leverage” for purposes of the retail commodity transaction definition.

Interestingly, the Securities and Exchange Commission filed a parallel action against the same defendant in which it characterized CFDs as security-based swaps. As a matter of statutory construction, a security-based swap is a “type” of a swap, which further supports the understanding that CFDs appear to be swaps and retail commodity transactions. Perhaps more about this on another day…

Good day. Good for something…we hope. DR2

]]>Cryptocurrency Derivatives, Funds and Advisers: Key Considerations Under U.S. Commodity Laws (Part 3: Why Commodity Interests Are of Interest)https://www.derivativesandreporeport.com/2018/10/cryptocurrency-derivatives-funds-and-advisers-key-considerations-under-u-s-commodity-laws-part-3-why-commodity-interests-are-of-interest/
Thu, 11 Oct 2018 00:14:50 +0000https://www.derivativesandreporeport.com/?p=2833Continue Reading]]>This post is the third in a series that outlines key considerations for investment funds and their advisers regarding the application of the U.S. commodity laws to cryptocurrency derivatives. This post is intended to be a primer on the topic and is not legal advice. You should consult with your counsel regarding the application of the U.S. commodity laws to your particular facts and circumstances.

In Part 1, we focused on the status of cryptocurrencies as commodities and how that status relates to the jurisdiction of the U.S. Commodity Futures Trading Commission (the “CFTC”). In Part 2, we provided an overview of the regulation of commodities and the commodity markets under the Commodity Exchange Act (the “CEA”), explaining in particular that while the authority to prevent fraud and manipulation may apply to any transaction in interstate commerce that involves a commodity, the CFTC’s “substantive regulation” applies only if a transaction involves a “commodity interest“.

Here, in Part 3, we explain why the concept of a commodity interest can be described as a “linchpin” to the substantive regulation of CPOs and CTAs.

Understanding Commodity Interests: A Key to Understanding U.S. Commodity Laws (Or, Why These Are the Interests of Interest)

The definitions of the terms commodity pool, CPO and CTA in sections 1a(10), 1a(11) and 1a(12) of the CEA, respectively, include a reference to commodity interests. At the risk of over-simplifying the statutory language, here is our attempt to provide a plain English application of these definitions in the general context of an investment fund:

If a fund invests or even has the ability to invest in commodity interests, then the fund will be a commodity pool and its operator will be a CPO and will be required to register with the CFTC as such or qualify for an exemption from registration.

Similarly, an adviser that provides advice or holds itself out as providing advice for compensation or profit about commodity interests will be a CTA that needs to consider registration or exemption from registration as such.

As a result, the term commodity interest serves as a “linchpin” to the substantive regulation of CPOs and CTAs (as well as other market intermediaries, such as firms that broker, deal or facilitate the execution of cryptocurrency derivative transactions).

For this reason, funds and advisers should analyze each investment to determine whether it is or may be a commodity interest.

Some investments may constitute what we refer to as “orthodox commodity interests” (for those familiar, we are re-purposing the “orthodox investment company” concept under Section 3 of the Investment Company Act of 1940 or the “ICA of 1940”). The prime example of such an interest is an exchange-traded futures contract. The analysis of such a commodity interest is not complicated – if it were a duck, it would be quacking.

But, the analysis of other crypto investments can be extremely nuanced and involve what we refer to as “inadvertent commodity interests” (again borrowing from the vocabulary of Investment Company Act regulation). In these situations, a particular token or transaction that involves a token may have characteristics that could result in that token or transaction being treated as a commodity interest, even if the token seller does not intend for that token to be a commodity interest. For example, if a token provides financial returns determined by reference to an identified asset without conveying an ownership interest in that asset, then the token could be a type of commodity interest.

Finally, one point is worth emphasizing (and, to an extent, repeating). As previously alluded to, being able to invest in a commodity interest is as important as actually investing in a commodity interest for purposes of the CPO and CTA regulatory analyses. So, disclosure in an offering memorandum stating that a fund is permitted to invest in orthodox commodity interests is sufficient to raise CPO and CTA analytical considerations, even if the fund does not actually invest in those interests.

So, having set the stage in this post as to why commodity interests are of interest to funds and advisers, our next post will explore the term commodity interests in greater detail.

Good day. Good background on why these interests are of interest? DR2.

]]>Cryptocurrency Derivatives, Funds and Advisers: Key Considerations Under U.S. Commodity Laws (Part 2: The Regulation of Commodities – Quite Substantial, Even If Not Substantive)https://www.derivativesandreporeport.com/2018/09/cryptocurrency-derivatives-funds-and-advisers-key-considerations-under-u-s-commodity-laws-part-2-the-regulation-of-commodities-quite-substantial-even-if-not-substantive/
Mon, 17 Sep 2018 16:22:48 +0000https://www.derivativesandreporeport.com/?p=2825Continue Reading]]>This post is the second in a series that outlines key considerations for investment funds and their advisers regarding the application of the U.S. commodity laws to cryptocurrency derivatives. This posting is intended to be a primer on the topic and is not legal advice. You should consult with your counsel regarding the application of the U.S. commodity laws to your particular facts and circumstances.

In Part 1, we focused on the status of cryptocurrencies as commodities and how that status relates to the jurisdiction of the U.S. Commodity Futures Trading Commission (the “CFTC”). Here, in Part 2, we provide an overview of the regulation of commodities and the commodity markets under the Commodity Exchange Act (the “CEA”).

The Regulation of Commodities – Quite Substantial, Even If Not Substantive

A primary purpose of the CEA and a primary mission of the CFTC is to prevent the manipulation of commodity prices (see Section 5 of the CEA); however, as will be explored in greater detail in the remainder of this series, the CEA does not substantively regulate every transaction that involves a commodity.

Note: As used in this series, the term “substantive regulation” means that a party to certain types of transactions involving commodities could be required to (1) register with the CFTC as a type of regulated market participant or (2) qualify for an exemption from such registration. In certain contexts, “substantive regulation” may also refer to the fact that the CEA and related CFTC regulations may place limitations on the transaction itself (e.g., restricting the types of market participants that can enter into the transaction, or whether the transaction can be entered into on a bi-lateral basis).

In light of the primary purpose of the CEA, U.S. commodity laws give the CFTC substantial anti-fraud and anti-manipulation jurisdiction over transactions in interstate commerce that involve a commodity (see Sections 6(c) and 9(a)(2) of the CEA and CFTC Regulations 180.1 and 180.2). It is worth emphasizing that a transaction does not have to involve a derivative (e.g., a swap or a futures contract), or even be entered into by the parties on a leveraged, margined or financed basis, for that transaction to be subject to the CFTC’s anti-fraud and market manipulation oversight. Further, based on several recent CFTC enforcement actions, it appears to be well established that the CFTC’s anti-fraud jurisdiction extends to the crypto asset class (see CFTC v. Gelfman Blueprint, Inc. and Nicholas Gelfman, No. 1:17-cv-07181 (S.D.N.Y. Sept. 21, 2017); CFTC v. My Big Coin Pay, Inc., Randall Crater, and Mark Gillespie, No. 18-10077-RWZ (D. Mass, Jan 16, 2018); CFTC v. Patrick K. McDonnell, and CabbageTech Corp. d/b/a Coin Drop Markets, No. 18-cv-0361, (E.D.N.Y. Jan 18, 2018)).

Funds and advisers should be aware of the CFTC’s anti-fraud authority, given the substantial potential scope of that authority. Practically speaking, in light of this authority, funds and advisers should design their crypto compliance trading policies based on the assumption that a fully funded purchase or sale of crypto for immediate delivery to the buyer (i.e., a spot transaction) falls within the anti-fraud and anti-manipulation enforcement authority of the CFTC.

However, as a conceptual matter, for investment funds and advisers to more fully understand the federal regulation of commodities and commodity markets in the U.S., it is helpful to distinguish between the following:

The CFTC’s substantial anti-fraud enforcement authority; and

The authority of the CFTC to substantively regulate aspects of certain types of transactions and the counterparties to those transactions (i.e., funds and advisers).

In sum, while the authority to prevent fraud and manipulation may apply to any transaction in interstate commerce that involves a commodity (including a spot transaction), the CFTC’s “substantive regulation” applies only if a transaction involves a “commodity interest“. We will explore both of these concepts in greater detail in the posts that follow.

Good day. Good Part 2, we hope. DR2

]]>CBOE and CME Self-Certify Bitcoin Futures, Cantor Self-Certifies Bitcoin Binary Options and NFA Issues Investor Alerthttps://www.derivativesandreporeport.com/2017/12/cboe-and-cme-self-certify-bitcoin-futures-cantor-self-certifies-bitcoin-binary-options-and-nfa-issues-investor-alert/
Fri, 01 Dec 2017 15:12:25 +0000https://www.derivativesandreporeport.com/?p=2756Continue Reading]]>It was a busy morning at the intersection of derivatives and virtual currencies. Here is an overview of what happened and some thoughts about what it means for the world of virtual currencies.

CME and CFE Self-Certify Futures Contracts – The Chicago Mercantile Exchange Inc. (“CME”) and the CBOE Futures Exchange (“CFE”) self-certified new contracts for bitcoin futures products. The CME will clear its own futures contract, while the CFE will clear its contract at the Options Clearing Corporation. According to a CME press release, the contracts will begin to trade on December 18th. Additional information about the CME’s product is available here. To our knowledge, the CFE has not yet announced a start date for the trading of its product.

CX Self-Certifies Fully-Funded Binary Option – Cantor Exchange (“CX”) self-certified a new fully funded, binary option contract on bitcoin, the salient features of which are summarized here. As with any binary option, this contract is a type of swap for U.S. regulatory purposes. CX provided the following summary of its product, ” [the contract] will be unleveraged and will offer the ability to trade over a range of bitcoin prices, and will trade for dates that are approximately one-month, two-months and three-months ahead. The contracts will be cash settled at 12 noon New York time on the last Friday of each calendar month based on a cash settlement price determined by Cantor Exchange.” Detailed information about the CX bitcoin swap is available here. CX will clear this product through Cantor Clearinghouse. To our knowledge, CX has not yet announced a start date for the trading of its product.

CFTC Issues Statement on These Self-Certifications – The CFTC issued a statement on these product developments, along with a background sheet that describes the regulatory self-certification process. That information is available here.

NFA Issues Investor Alert on Virtual Currency Futures Contracts – The National Futures Association (the “NFA”), the self-regulatory organization for the derivatives industry, issued an Investor Alert entitled, Futures on Virtual Currencies Including Bitcoin which is available here. In summary, the alert outlines the risks of trading futures contracts on virtual currencies.

What does all of this mean to “crypto-watchers” and derivatives market participants, including institutional and retail investors?

The world of virtual currencies is about to simultaneously become a lot more institutional and a lot more retail. Exchange-traded products are available for investment by institutional investors, like hedge funds and mutual funds, as well as retail investors. The former will have to give consideration to the application of existing regulatory constructs (like custody and status as a commodity pool operator or commodity trading advisor), if they intend to engage in the trading of these products; while the latter will need to learn more about these products so that they are not surprised by losses or the effect of leverage, margin calls, and related considerations. In addition, both types of investors will need to consider the effect of the applicable position limit and accountability level reporting at the levels of the exchange.

And, it also means that the world of virtual currencies will be subject to a whole new level of increased regulatory oversight, since more attention will be given to the asset class by the CFTC, the NFA, and the exchanges that offer these products.

Good day. Good amount of activity for the first of December! DR2

]]>CFTC Grants CPO/CTA No-Action Relief to Oil and Gas Fund and Its Operating Subsidiarieshttps://www.derivativesandreporeport.com/2017/09/cftc-grants-cpocta-no-action-relief-to-oil-and-gas-fund-and-its-operating-subsidiaries/
Tue, 26 Sep 2017 20:23:02 +0000https://www.derivativesandreporeport.com/?p=2713Continue Reading]]>In CFTC Letter 17-48, the Division of Swap Dealer and Intermediary Oversight (the “Division”) of the Commodity Futures Trading Commission (the “CFTC”) indicated that it would not recommend enforcement action against the manager of a oil and gas fund and its subsidiaries for failure to register as a commodity pool operator (“CPO”) or a commodity trading advisor (“CTA”). As background, the manager intended to use over-the-counter swap transactions (“Swaps”) to hedge commodity price risks relating to oil and natural gas investments made by the fund and its subsidiaries (collectively, the “Fund”). The following are the key facts presented in CFTC Letter 17-48:

The Fund owns working interests, mineral interests, and overriding royalty interests in crude oil and natural gas producing and non-producing properties in Montana, North Dakota, and Oklahoma.

The Fund enters into Swaps in an attempt to hedge its exposure to commodity price risk as a result of the acquisition of the crude oil and natural gas interests.

The Swaps would constitute “bona fide hedging positions,” as that term is used in a rule proposed by the CFTC to establish position limits that apply to certain physical commodity derivatives.

The notional value of the Swaps corresponds with a specified percentage of proved producing reserves. The Swaps are intended to reduce the risk posed to the Fund by fluctuations in crude oil and natural gas pricing.

The Fund does not intend to “trade in and out” of the swaps to generate profits or mitigate losses. The Swaps will not be used to generate investment income.

As a result of its use of the Swaps, the only “new” risk to which the Fund is exposed is the risk that the counterparties to the swaps will not perform their obligations in respect of the Swaps (i.e., counterparty credit risk).

The only commodity trading advisory activities of the Fund’s manager are its activities in respect of the Swaps.

The Fund and its manager will implement risk management policies and procedures reasonably designed to ensure compliance with the terms and conditions of CFTC Letter 17-48.

On the basis of these facts, the Division granted no-action relief allowing the Fund’s manager to avoid registration as a CPO/CTA, subject to the satisfaction of the following six conditions:

Risk Reduction Effect – The overall riskiness of the Fund’s investments will be lower as a result of the use of the Swaps;

No Speculation or Trading – The Swaps cannot be established, held, altered or terminated for the purposes of speculation or trading;

Hedging of Physical Risks Only – The Swaps can only be used to hedge commodity price risk of the Fund’s physical assets, and notthe risks arising from the arrangement by which the Fund’s assets are held or financed;

Counterparty Risk Only – The only “new” risk introduced to the Fund through the use of the Swaps is counterparty credit risk;

Market Standard Terms – The terms and conditions of the Swaps will be consistent with generally available market terms; and

Implementation of Risk Management Policies and Procedures – The Fund (including its subsidiaries) and its manager will employ risk management policies and procedures reasonably designed to ensure compliance with the terms and conditions of CFTC Letter 17-48. These policies and procedures will include periodic testing to confirm on-going compliance with the letter with respect to any amendments to the Swaps or the structure of the Fund.

]]>Attention Non-U.S. Funds and Advisers: Registration Exemption for Offshore CPOs, CTAs and IBs That Use Non-Cleared Derivativeshttps://www.derivativesandreporeport.com/2016/02/attention-non-u-s-funds-and-advisers-registration-exemption-for-offshore-cpos-ctas-and-ibs-that-use-non-cleared-derivatives/
Sat, 13 Feb 2016 16:28:24 +0000https://www.derivativesandreporeport.com/?p=2503Continue Reading]]>On February 12th, the Division of Swap Dealer and Intermediary Oversight (the “Division”) of the United States Commodity Futures Trading Commission (“CFTC”) issued CFTC Letter No. 16-08. This no-action letter clarifies that an intermediary located outside of the United States (a “Foreign Intermediary”) will not need to register as commodity pool operator (“CPO”), a commodity trading advisor (“CTA”), or an introducing broker (“IB”), as long as the following conditions are met:

The Foreign Intermediary is located outside the United States; and

The Foreign Intermediary acts only on behalf of persons located outside the United States.

This posting provides additional information in respect of this no-action letter, which we expect will be of interest to non-U.S. hedge funds and investment advisers that use CFTC-regulated derivatives in connection with their investment strategies.

Background: CFTC Regulation 3.10(c)(3)(i) and Why This Relief Was Necessary

CFTC Regulation 3.10(c)(3)(i) is an exemption from registration as a CPO, CTA, or IB available to a Foreign Intermediary such as a non-U.S. hedge fund manager. The exemption applies to activities that involve commodity interests (i.e., CFTC-regulated derivatives such as futures contracts, swaps, etc.) executed bilaterally or over a CFTC-regulated futures exchange or swap execution facility (a “SEF”).

A Foreign Intermediary can rely on this exemption, as long as the following conditions are met:

The Foreign Intermediary is located outside the United States;

The Foreign Intermediary acts only on behalf of persons located outside the United States; and

The commodity interest transaction is submitted for clearing through a registered futures commission merchant (“FCM”).

The third condition means that a Foreign Intermediary is unable to rely on CFTC Regulation 3.10(c)(3)(i), if any of its derivative investment activities involve bi-laterally executed, non-cleared contracts (e.g., an over-the-counter (OTC) swap of the type that is commonly entered into by parties pursuant to an ISDA Master Agreement). As pointed out by the trade associations that sought this relief (the Investment Adviser Association and the Asset Management Group of the Securities Industry and Financial Markets Association), this condition is not reasonable since not every swap is requiredto be cleared or even capableof being cleared by an FCM (i.e., no central counterparty offers to clear a particular swap).

The Division’s No-Action Position

Given that background, many non-U.S. market participants have been “scratching their heads” for the past several years: they appeared to have an exemption from registration as a CPO, a CTA or an IB available to them, but could not rely on that exemption because of a completely unrealistic condition.

The Division appears to agree. This is the exact language of the Division’s No-Action Position:

The Division believes that Regulation 3.10(c)(3)(i) was not intended to impose an independent clearing requirement on commodity interest transactions involving Foreign Intermediaries that the [Commodity Exchange Act] and [CFTC] Regulations do not otherwise require to be cleared…Accordingly, the Division will not recommend an enforcement action against a person located outside the United States, its territories or possessions engaged in the activity of [a CPO, a CTA, or an IB] in connection with swaps not subject to a [CFTC] clearing requirement only on behalf of persons located outside the United States, its territories or possessions. [Footnotes omitted.]

Put another way, a Foreign Intermediary can rely on the exemption available under CFTC Regulation 3.10(c)(3)(i), even if its activities involve bi-laterally executed, non-cleared derivatives.

Administrative History: Thou Shalt Not SolicitU.S. Customers

This no-action relief is a significant and important development for non-U.S. funds and advisers. And, the issuance of the relief presents market participants with a good opportunity to reflect on the administrative history of this exemption. In connection with its adoption of CFTC Regulation 3.10(c)(3)(i) in 2007, the CFTC made the following point:

If a person located outside the U.S. were to solicit prospective customers in the U.S. as well as outside of the U.S., [the exemption under CFTC Regulation 3.10(c)(3)(i)] would not be available, even if the only customers resulting from the efforts were located outside the U.S.Exemption from Registration for Certain Foreign Persons, (Nov. 14, 2007) 72 FR 63976 at 63978 (footnotes omitted), available here.

Or, as I have said before in another context, the CFTC’s view can be summarized as follows: “Our markets are your markets (but stay away from our investors).”

As a reminder, any person claiming certain relief from the requirement to register as a commodity pool operator (CPO) or commodity trading advisor (CTA) must submit an annual affirmation to the National Futures Association (“NFA”) by February 29, 2016. In particular, such affirmation must be filed by any person relying on the exemption or exclusion available under any of the following Commodity Futures Trading Commission (“CFTC”) rules:

Rule 4.5;

Rule 4.13(a)(1);

Rule 4.13(a)(2);

Rule 4.13(a)(3);

Rule 4.13(a)(5); or

Rule 4.14(a)(8), which is the only relief available to CTAs (i.e., the relief available under all of the other rules applies to CPOs).

The affirmation process is important, since a failure to affirm an active exemption or exclusion from CPO or CTA registration by February 29, 2016 will result in the exemption or exclusion being withdrawn on March 1, 2016. In turn, the formerly exempt CPO or CTA:

1) will be subject to the regulatory requirements that apply under Part 4 of the CFTC’s rules; and

2) may be subject to an enforcement action by the CFTC.

The NFA has published a very useful guidance notice (Notice to Members I-15-26: Guidance on the annual affirmation requirement for entities currently operating under an exemption or exclusion from CPO or CTA registration), which you can access here. Among other things, the notice provides information about the mechanics of the affirmation process, a helpful “Q&A,” and NFA contacts for any questions about the affirmation process.

Good day. Good affirming. DR2

]]>NFA Notice to Members I-15-02: Affirm CPO/CTA Exemptions and Exclusions by March 2nd, NFA Members Given Tools to Monitor Affirmationshttps://www.derivativesandreporeport.com/2015/01/nfa-notice-to-members-i-15-02-affirm-cpocta-exemptions-and-exclusions-by-march-2nd-nfa-members-given-tools-to-monitor-affirmations/
Fri, 16 Jan 2015 16:44:08 +0000http://www.derivativesandreporeport.com/?p=2324Continue Reading]]>On January 15th, the National Futures Association (“NFA”) issued its Notice to Members I-15-02 (the “NTM”).

The NTM will be of interest to NFA Members, such as futures commission merchants (“FCMs”) and introducing brokers (“IBs”), and any entity in a mutual or hedge fund complex that has not yet affirmed its status for calendar year 2015 as:

The remainder of this posting is an overview of the NTM, which is available here.

A Reminder for Exempt or Excluded CPOs/CTAs to Affirm Their Status By March 2nd…

Several CFTC rules provide investment funds and their operators and advisers with a number of exemptions or exclusions from the requirement to register as a CPO or CTA, subject to the additional requirements that a person:

File a notice of eligibility with the NFA to claim the exemption or exclusion; and

Annually affirm its eligibility to claim such exemption or exclusion within sixty (60) days of each calendar year end.

The NTM addressed the particular situation in which a fund operator or adviser previously claimed:

An exemption from CPO registration under CFTC Regulation 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), or 4.13(a)(5);

An exclusion from CPO registration under CFTC Regulation 4.5; or

An exemption from CTA registration under CFTC Regulation 4.14(a)(8);

but has not yet affirmed its eligibility to claim such exemption or exclusion for calendar year 2015, filed a notice of eligibility in respect of another available exemption or exclusion, or properly regsitered as an NFA member by December 31, 2014.

Exempt or excluded CPOs/CTAs have until March 2, 2015 to submit their annual affirmations in respect of calendar year 2015. Failure to do so by that date will result in such person being deemed to have requested a withdrawal of the exemption. As a result, that person may be required to be registered with the NFA as a CPO or a CTA, as applicable, or stop using CFTC- regulated investments in connection with the management of the relevant investment portfolio(s).

…Your FCM Will (Must) Be Watching

NFA Bylaw 1101 imposes strict liability on any NFA Member (such as an FCM or IB) that conducts customer business with a non-Member that is required to be registered as an NFA Member. A similar requirement is found in NFA Compliance Rule 2-36(d), which applies to certain activities in the foreign exchange (or forex) markets.

Consitent with these requirements, the NFA expressed its expectation that any FCM or other NFA Member that transacts customer business with a fund operator or adviser that has not yet affirmed its status as an exempt or excluded CPO/CTA “promptly contact the [fund operator or adviser] to determine whether it intends to file a notice affirming the exemption [or exclusion].”

If the Member learns that the fund operator or adviser does not intend to file its affirmation (or such person does not file actually file its affirmation by the March 2nd deadline), then the Member must:

promptly obtain a written representation as to why the person is not required to register or file a notice of eligibility in respect of the exemption or exclusion; and

evaluate whether the representation appears to be adequate based upon the information that the Member knows about the person.

If the Member ultimately determines that the person’s written representation is inadequate and the person is required to be registered, then the Member must put a plan in place (e.g., liquidation-only trades) to cease transacting customer business with the person or risk violating NFA Bylaw 1101 or Compliance Rule 2-36(d).

The NFA also expects its members to “use reasonable steps to identify those [exempt or excluded CPOs/CTAs] who currently claim an exemption [or exclusion] from CPO/CTA registration with whom the Member transacts customer business.” To that end, the NFA is providing its Members with access to a spreadsheet that lists all persons that have exemptions or exclusions from registration as a CPO/CTA on file with the NFA that must be affirmed on an annual basis. The spreadsheet will be updated nightly and include the following information:

Each person claiming an exemption or exclusion from CPO registration;

Each pool for which such operator claims an exemption or exclusion;

Each person claiming an exemption from CTA registration;

The partciular exemption on file with the NFA;

The last date on which such exemption was affirmed by that person; and

The most recent date on which the affirmation is due.

This information is intended to enable the Member to determine that an exemption or exclusion has not yet been affirmed in the manner required by the relevant CFTC Regulations.

If a Member acts in accordance with the guidance provided in the NTM, then the NFA will not charge that Member with violating NFA Bylaw 1101 or Compliance Rule 2-36(d).